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John Lawson: The full cost of the charge cap

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The DWP’s pension charge cap consultation proposes a range of charge cap options but it is far from clear at this stage what it is they plan to cap. More needs to be understood about transaction costs before we can conclude whether their inclusion or exclusion from a charge cap is the right decision. However, one thing is clear, once these costs are revealed advisers and clients will never look at funds the same way again.

The pension charges that are most visible are the annual management charge, or AMC, and the total expense ratio or TER. The former covers a wide range of pension provider or scheme costs, such as administration, fund management, marketing, commission and other sales costs. The TER adds registration, audit and depositary costs to the AMC.

What is currently invisible to advisers and the wider public are trading or transaction expenses, which are incurred in buying and selling the underlying assets of the fund. 

For most funds, these fall into three broad categories; brokerage, stamp duty and bid/ask spreads. These costs are reflected implicitly in the performance of the fund.

The size of these costs depends upon a wide range of factors but the most important is how regularly the fund is sold and repurchased. This is called the turnover rate. 

For example, if the cost of buying and repurchasing the whole fund is say 1.5 per cent, then the transaction cost will equal 1.5 per cent if the fund is turned over every year. But if the fund is turned over only once every 10 years, the annualised cost of turnover will be just 0.15 per cent
or 15 basis points.

The Investment Management Association has already published a code covering the disclosure of these costs for mutual (retail) funds. It expects investment managers covering over 96 per cent of retail funds to disclose these costs, mostly by the end of this year.

Life company funds, where most DC pension money is invested, will take longer to reach this standard, as accounting for these costs now takes place at the level of the life company rather than the fund. But insurers are expected to disclose these costs to the independent governance committees that will oversee contract-based pensions next year. Disclosing these expenses will allow all governors of investments, from advisers to trustees to individual customers to compare fund performance not just in nominal terms but also in terms of what is happening under the bonnet. Statistics will reveal the correlation or otherwise between fund performance and how frequently each fund trades.

Whether including these costs within a cap is a good thing or not is another matter. Pension schemes and providers may be prevented from trading when they want to because the cost of trades might force them over the cap. Others might conclude not trading at all is the best way to keep costs down, so the limited money raised from charges within the cap may be spent on other things such as communication.

To be transparent, it is vital that all involved, from contract-based providers, to trust-based DC schemes to discretionary managers all reveal their transaction costs to be measured by the same yardstick. Only then will we be able to make informed choices

John Lawson is head of policy at Aviva

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